Moneyness of Options

The moneyness of an option is a fascinating classification system that breathes life into the world of options trading. Imagine standing at a crossroads, where each path represents a different potential outcome for your trade. These paths are-

1) In the Money (ITM)

2) At the Money (ATM)
3) Out of the Money (OTM)

These aren't just abstract concepts; they are pivotal in shaping your trading decisions and strategies. Understanding which path to take can be the difference between a successful trade and a missed opportunity. Before diving into the nuances of these classifications, let's revisit the cornerstone of their significance: intrinsic value.

Intrinsic value as previously discussed is the real, tangible benefit an option holder gains, the profit that materialises if the option is exercised at that moment. Intrinsic value is never negative, a reassuring constant in the unpredictable dance of the markets. To illustrate, let's explore a scenario that brings this concept to life.

Imagine the underlying asset is the Nifty 50, with a current spot value of 22,500. You've purchased a call option (CE) with a strike price of 22,300, and there are 21 days left until expiration. But instead of waiting, you decide to exercise your option today. How much money would you make?

The money you earn from exercising a long option is its intrinsic value minus the premium paid. To find the intrinsic value, we use a simple formula:

Intrinsic Value of a Call Option = Spot Price - Strike Price

Plugging in the current values:

22,500- 22,300 = 200 

So, if you exercise the option today, you'd make 200 points (ignoring the premium paid). Here's a table summarising the data:

With this data, if you decide to exercise your call option today, your intrinsic value would be 200 points. This straightforward calculation helps you see the potential profit and make informed trading decisions. 

Now, let's see how intrinsic value works with various options strikes in different scenarios:

From these examples, you can see how intrinsic value is calculated for different scenarios:

1. Intrinsic value of an option is the amount of money you would make if you were to exercise the option contract.

2. Intrinsic value of an options contract can never be negative. It can either be zero or a positive number.

3. Call option intrinsic value = Spot Price – Strike Price.

4. Put option intrinsic value = Strike Price – Spot Price.

Why Intrinsic Value Can Never Be Negative

Let's dive deeper into why the intrinsic value can never be negative. Suppose the strike price is 18,300, the spot price is 18,200, and you're holding a long call option. For this option, you paid a premium of Rs.128.

1. If you were to exercise this option, what would you get?

   You would get the intrinsic value.

2. How much is the intrinsic value?

   Intrinsic Value = 18,200 - 18,300 = -100.

3. The formula suggests we get '-100'. What does this mean?

   This means you would be losing Rs.100.

4. Let’s believe this is true for a moment. What will be the total loss?

    128 + 100 = Rs.228.

5. But we know the maximum loss for a call option buyer is limited to the extent of the premium paid, which is Rs.128 in this case.

    If we include a negative intrinsic value, this property of option payoff is not obeyed (Rs.228 loss instead of Rs.128).

Therefore, to preserve the non-linear payoff property of options, intrinsic value cannot be negative. The same reasoning applies to the calculation of intrinsic value for put options.

Hopefully, this clarifies why the intrinsic value of an option can never go negative and highlights its importance in guiding your trading decisions.

Now that we have understood the intrinsic value of options in depth. So , let us now try to wrap our heads around the moneyness of options as it is crucial for any trader aiming to make informed decisions in the options market. Moneyness categorises options based on their intrinsic value, which determines whether an option is profitable to exercise at a given point in time. This classification applies to both call and put options and includes the following categories:

1. In the Money (ITM)

2. At the Money (ATM)

3. Out of the Money (OTM)

Additionally, we have sub-categories such as Deep ITM and Deep OTM to further refine our understanding. Let's delve into these classifications with reference to current Nifty values.

Moneyness of Call Options

Let's say the current Nifty Value is 22,000. Then ATM ,ITM and OTM options would go like this -

At the Money (ATM) Call Options

An ATM call option is one where the strike price is closest to the current Nifty value. For instance, if Nifty is at 22,000, then the 22,000 strike price is considered the ATM call option. Likewise, if Nifty price falls at 21987 , then  it would still be considered as having an ATM value of 22,000 as it is the closest strike price near the spot price.

Hope this clears out ATM options.Also understanding ATM options is crucial because it acts as the pivot point around which ITM and OTM classifications revolve.

Now Let us discuss , In the Money (ITM) Call Options

A call option is ITM when its strike price is below the current Nifty value. ITM options have intrinsic value because the option holder can exercise the option at a profit. Here are some examples based on a Nifty value of 22,000:

Certainly, let's focus on positive intrinsic values for In the Money (ITM) call options:

1. Strike Price 21,900

• Intrinsic Value = 22,000 - 21,900 = 100

• This option is clearly ITM with a positive intrinsic value of Rs. 100, indicating potential profit upon exercise.

2. Strike Price 21,700:

• Intrinsic Value = 22,000 - 21,700 = 300

• Similarly, this option is ITM with a higher intrinsic value of Rs. 300, suggesting a stronger potential for profit upon exercise.

3. Strike Price 21,500:

• Intrinsic Value = 22,000 - 21,500 = 500

• With a positive intrinsic value of Rs. 500, this option is firmly ITM, highlighting a significant potential for profit upon exercise.

By examining these examples, it becomes clear that ITM call options offer profit potential when their strike prices are lower than the current Nifty value. The higher the intrinsic value, the greater the profit potential upon exercise.

ITM options are more expensive due to their inherent value and higher likelihood of being exercised profitably and the deeper these strike prices are they have more profitability ,hence are called deep ITM options.

Let's explore Out of the Money (OTM) call options with more thought-provoking examples:

1. Strike Price 22,300

• Intrinsic Value = 22,000 - 22,300 = -300

• This option demonstrates a negative intrinsic value of Rs. -300, unequivocally placing it in the OTM category. Despite the potential for a loss upon exercise, it remains out of the money.

2. Strike Price 22,600 :

• Intrinsic Value = 22,000 - 22,600 = -600

• Similarly, this option exhibits a negative intrinsic value of Rs. -600, reaffirming its status as an OTM option. With no profitability upon exercise, it remains out of the money.

3. Strike Price 22,100 :

• Intrinsic Value = 22,000 - 22,100 = -100

• Despite the relatively smaller negative intrinsic value of Rs. -100, this option still falls within the OTM category. It emphasises the nuanced nature of OTM options, where even minimal deviations from the current Nifty value can result in being out of the money.

By contemplating these examples, it becomes clear that OTM call options lack intrinsic value and are thus considered out of the money. While they may appear more affordable, they also pose higher risk as they rely on significant price movements to become profitable.

Now you might be thinking, "Do I have to calculate the intrinsic value every time before entering a trade to determine if an option is ATM, ITM, or OTM?" The answer is a resounding NO! Thankfully, you don’t need to do these calculations manually. This is where the "Option Chain" comes in, which we'll cover in detail later on but let us first understand moneyness of put options 

Moneyness of Put Options

Let's say the current Nifty Value is 22,000. Then ATM ,ITM and OTM options would go like this -

At the Money (ATM) Put Options

Similar to call options, the ATM put option has a strike price closest to the current Nifty value. For a Nifty value of 22,000, the 22,000 strike price is the ATM put option.Likewise, if Nifty price falls at 22021,then  it would still be considered as having an ATM value of 22,000. 

In the Money (ITM) Put Options

A put option is ITM when its strike price is above the current Nifty value. ITM put options have intrinsic value as the option holder can sell the underlying asset at a higher price than the current market value:

Certainly! Let's delve into In the Money (ITM) put options with detailed examples:

1.Strike Price 22,200

• Intrinsic Value = 22,200 - 22,000 = 200

• With a positive intrinsic value of Rs. 200, this option is clearly ITM. It holds value because the option holder can sell the underlying asset at a price higher than the current market value, ensuring profitability upon exercise.

2. Strike Price 22,400:

• Intrinsic Value = 22,400 - 22,000 = 400

• This option is ITM with an intrinsic value of Rs. 400. The higher the intrinsic value, the deeper the moneyness, indicating a greater potential for profit.

3. Strike Price 22,500:

• Intrinsic Value = 22,500 - 22,000 = 500

• With an intrinsic value of Rs. 500, this option is deeply ITM. It showcases a significant profit potential upon exercise due to the substantial difference between the strike price and the current market value.

 It highlights the profitability available to the option holder by selling at a price higher than the current market value.

ITM put options possess intrinsic value, making them more expensive due to their higher probability of being exercised profitably. Understanding the concept of ITM put options helps traders identify opportunities to maximise gains by selecting options with a favourable strike price relative to the current market value.

ITM put options tend to be more expensive due to their higher intrinsic value and probability of profitable exercise.

Out of the Money (OTM) Put Options

A put option is considered OTM when its strike price is below the current Nifty value. These options do not have intrinsic value, as exercising them would not be profitable at the moment.

Examples of OTM Put Options:

1.Strike Price 21,800:

• Intrinsic Value: 21,800 - 22,000 = -200

• As intrinsic value cannot be negative, it is considered zero. This option is OTM since the strike price is below the current Nifty value.

2. Strike Price 21,500:

• Intrinsic Value : 21,500 - 22,000 = -500

• Again, with a negative calculation for intrinsic value, it defaults to zero. This option is OTM, reflecting the unprofitable position of selling the asset at this strike price.

3.Strike Price 21,900:

• Intrinsic Value: 21,900 - 22,000 = -100

• This option is also OTM as the intrinsic value is zero, indicating no profit from exercising the option.

4. Strike Price 21,600:

• Intrinsic Value - 21,600 - 22,000 = -400

• With zero intrinsic value, this option is OTM and holds no immediate profit potential.

OTM put options are typically less expensive because they have no intrinsic value and are currently unprofitable to exercise. These options rely on a significant drop in the underlying asset's price to gain value, making them riskier but potentially rewarding if market conditions change favourably. Understanding OTM put options helps traders manage risk and identify strategic entry points for potential future profits.

OTM put options are less expensive but carry more risk since they require a downward price movement to become valuable.

Now that we've clarified the concept of option moneyness, let's explore option chain, which simplifies the process of evaluating options. While the option chain contains numerous terms, we'll focus only on the key ones for now, setting aside others for future discussion. 

The table shown above is referred to as an 'Option Chain'. You can access the Option Chain by clicking on the F&O option, located at the top left next to the cash option in “Tick2Trade” (highlighted in red). This table displays various strike prices available for a particular contract, along with their associated premiums.

Understanding the Option Chain

Let's take a closer look at some key observations that will help you navigate the option chain more effectively:

1. The current spot price of the NIFTY is displayed at the top ( marked in blue colour ), making it easy to identify.

2. On the option chain, call options are listed on the left side.

3. Conversely, put options are shown on the right side.

4. The strike prices are arranged in ascending order in the center.( marked in the red colour box)

5. Given the spot price, the nearest strike price is considered the ATM option and is typically highlighted for easy identification.(here ATM price is 23200 and at Tick2Trade we have also marked a yellow line which differentiates the ITM and OTM options)

6. For call options, any strike price lower than the ATM is classified as ITM and is often shaded to distinguish it.

7. Strike prices higher than the ATM for call options are considered OTM and usually have a different background colour. (here ITM options are highlighted in a little dark colour and OTM are shaded light)

8. For put options, strike prices higher than the ATM are ITM and are similarly shaded.

9. Put option strike prices lower than the ATM are OTM and are marked accordingly.

Now at a glance, it is evident that all the highlighted options on the left side of the option chain are ITM call options, while the unhighlighted ones are OTM call options. Similarly, on the right side, the highlighted options represent ITM put options, and the unhighlighted ones are OTM put options.

Now, it's time for a little homework. Your task is to cross-reference whether all the options highlighted in colour are truly ITM or not, and likewise, whether the uncolored options are OTM or not. By verifying these classifications, we'll ensure accuracy in our analysis. Moving forward, we'll rely on the option chain to select our strike prices, as it offers a quicker and more efficient alternative to manually calculating each premium.

Now that we understand call and put options, including ITM, OTM, and ATM distinctions, let's dive into Option Greeks. We'll explore their impact on option premiums and briefly cover the Black-Scholes Option Pricing Formula to enhance our trading strategies. Ready to delve into these intriguing topics? Let's move on to Option Greeks.